The aid, which the source close to the situation put at between 5 billion euros ($6.5 billion) and 7 billion, would help the group offer cheaper financing to car buyers and shows how Peugeot is being thrust into the arms of the French state.

The company's efforts to restructure on its own have fallen short amid a shrinking auto market and the group suffered a downgrade by credit rating agency Moody's this month, raising the likelihood that its financing arm Banque PSA Finance (BPF) would also be downgraded to junk status.

Mood's cut the parent automaker, which also includes the Citroen marque, to Ba3, three notches below investment grade.

Peugeot faces a widening competitiveness gap with rivals such as Volkswagen AG , which are vying for a slice of the shrinking European car market, as downgrades would make its car loans more expensive.

Industry Minister Arnaud Montebourg has said the French state was willing to provide guarantees for BPF but that any aid would come with strings attached.

Montebourg told Liberation newspaper on Tuesday that France wanted Peugeot to appoint government and worker representatives to its board, reduce planned job cuts and guarantee domestic plants in return for a lending bailout.

As part of the plan, Peugeot's lending banks have reportedly agreed to back the government's action with a promise of around 5 billion euros in loans. A banking source said the banks had agreed to postpone some repayments, while a second banker said Peugeot was an important customer and would be supported.

Representatives from Peugeot were due to meet with government officials at the prime minister's office on Tuesday.

A spokesman for Peugeot had no comment.

STRICT CONDITIONS

The French state has no stake in Peugeot, which in July announced 8,000 job cuts and the closure of an assembly plant to halt spiraling losses.

France will likely have to impose strict conditions on the guarantee if it is to comply with EU rules on state aid, lawyers and bankers say.

This would include financial compensation for the guarantee, which Commission rules state must be in accordance with market rates, while some bankers say Peugeot may have to go further and sell some loans or find an outside investor for its financing arm.

But already the German state of Lower Saxony, a major Volkswagen shareholder, has reportedly said it would oppose the Peugeot aid plan as a possible breach of EU rules.

Brussels has not yet been informed of any bailout agreement and cannot comment on the specifics of the case, a European Commission spokesman said.

Once notified, the EU regulator examines aid packages as well as the terms under which they are granted, the spokesman added. "The Commission ensures ... that there are no protectionist conditions placed on the attribution of aid."

Paris was forced to modify its last auto sector bailout in February 2009, after the Commission objected to conditions attached to 6 billion euros of state loans for Peugeot and Renault - including proposals that the carmakers undertake to maintain all domestic plants.

Rescue deals with carmakers should "not contain any condition concerning either the location of their activities or the requirement to prioritize France-based suppliers", the EU executive said at the time. ($1 = 0.7651 euros)